International Completion Strategies

During the past 10 years, institutional investors have shifted asset allocations away from their home country biases. Despite this trend, it has not been enough to align their allocation with the global markets, says Greg Behar, senior investment strategist, Northern Trust global index management group.

According to Pensions & Investments, in 2008, the top 200 U.S. defined benefit (DB) funds allocated only 33.2% of their portfolios to international funds. “This is a significant underweight to international equities if you look at global benchmarks such as MSCI where the non-U.S. market represents 56.8% of global equities,” Behar adds.

Another factor that hinders investors’ potential to participate in global growth opportunities is that many strategies tend to concentrate exposure to large-cap equities of developed and emerging countries. “That may be due, in part, to the benchmark selected,” notes Stefanie Hest, senior investment strategist, Northern Trust global index management group. “By underweighting their portfolio allocation to developed international small-cap, emerging market small-cap and frontier market sub-asset classes, investors may forgo a significant portion of the opportunity set and miss an opportunity to diversify their portfolios,” she adds.

An International Equity Mix

The MSCI EAFE has been the standard benchmark for U.S. investors seeking international exposure for more than 30 years. Although it continues to provide a comprehensive proxy for developed international large-cap equities, MSCI EAFE only captures 69% of the total non-U.S. equity market cap, rendering it an outdated proxy for true global non-U.S. equity markets, notes Behar. “That’s a stumbling block,” he says.

Until recently investors have been slow to adopt benchmarks that completely measure the full international opportunity set. “As a result, investors using the MSCI EAFE Index as a performance benchmark tend to systematically underweight the other 31% of the international opportunity set,” Behar says.

More progressive investors have shifted from an MSCI EAFE benchmark to the broader MSCI All Country World excluding U.S. benchmark, which includes emerging markets. Yet, they are still leaving opportunity on the table with regard to developed international and emerging market small cap, and frontier market companies.

Investors should consider shifting to newer, more complete “total international equity” benchmarks, Behar says. In November 2006, MSCI announced that it would update its benchmark methodology in the MSCI Global Investable Market Indexes (GIMI) to include non-overlapped asset class subsets for both developed and emerging large-, mid- and small-cap equities. Such benchmarks would include the MSCI All Country World Investable Market Index (ACWI IMI). “These new indexes more closely resemble the broad representation of major U.S. indexes, such as the Russell 3000 or Dow Jones Total Market Index, and help investors incorporate a truly international equity mix into their portfolios,” Hest says.

Benchmark providers such as Standard & Poor’s and MSCI have also created benchmarks that allow for exposure to frontier markets. “Frontier markets are the remaining piece of the puzzle to complete the investable international opportunity set,” Behar says.

Emerging Market Indexes Offer Diversity

Historically, U.S. investors looked to international equities to provide diversification within a portfolio. However, as the recent global recession demonstrated, the correlation between U.S. and non-U.S. equities has increased. The correlation between the S&P 500 and MSCI EAFE was a moderately low 0.54 in the 1990s and increased to 0.88 from January 2000 to December 2009. During this period, emerging market equities have exhibited higher correlations with both the developed markets including the U.S. market.

While the MSCI EAFE and MSCI Emerging Market indexes have become more highly correlated to U.S. equities than in the past, its bias toward large- and mid-cap equities doesn’t provide the full correlation picture. According to Behar, “Developed small-cap, emerging small-cap and frontier sub-asset classes — which comprise $2 trillion of market cap or 12% of the $16.5 trillion total international equity opportunity set — are less correlated to the global economy and can offer diversity to a portfolio.”

Emerging Markets Grow Up

In 1988, emerging markets represented 1% of the world market capitalization. Two decades later, they now represent 13%. Emerging markets also have different characteristics than in the past. In the 1990s emerging market growth was driven solely by commodities and exports to developed markets such as the United States. Today, these markets are importers and consumers in their own right. “There is now the belief that 50% of China’s goods are exported to other emerging markets,” Behar says. “Other emerging markets have implemented financial controls that make them more attractive to investors. Brazil, for example, was plagued by hyperinflation in the 1990s, but it implemented policies to control inflation to the single digits.”

“As emerging market companies become more global, some investors are looking to the next generation of emerging markets,” Behar says. Frontier markets are developing countries with high economic growth rates and small, relatively illiquid and undercapitalized equity markets such as Nigeria, Kenya, Vietnam, Sri Lanka, Croatia, Romania, Qatar and Kuwait.

Some investors are hoping that frontier markets, which represented approximately 1% of world market cap in 2009, will have a similar trajectory as emerging markets. “Time will only tell if that comes to pass,” Behar says. “But the potential is there for significant economic growth in these frontier markets.”

Frontier markets have experienced strong economic growth in the last few years, significantly outpacing both developed and emerging markets. “Despite this growth, frontier market economies remain very small compared to developed and more advanced emerging market countries, which leaves room for steady equitization of their economies,” Behar says. However, he notes that investors who want to add frontier markets to their portfolio should look for a broad exposure rather than investing in only a few frontier markets because of the inherent risks — from political unrest to operational, regulatory and market risk — that exist in individual countries.

Regardless of the benchmark or investment approach they use, investors should not ignore the international developed small-cap, emerging small-cap and frontier markets. “Incorporating these three sub-components of the global markets tends to provide investors with a complete and efficient global equity allocation,” Hest says.

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